MIKE TOWNSEND: As Congress races toward its beloved August recess, lawmakers are scrambling to get key pieces of legislation across the finish line before the break. A long-stalled China competition bill that includes a boost for the U.S. semi-conductor industry looks poised to pass both the House and the Senate this week. And Democrats are also trying to finish a bill to lower prescription drug prices.
Meanwhile, the Fed took another big step in its battle to combat inflation, and economists continued to puzzle over whether the confusing economic data has the United States headed into a recession. And there was a surprising request from the largest cryptocurrency exchange to the SEC: Please regulate us.
Overseas, the Russia-Ukraine war drags on, and new tensions with China cast yet another shadow over the U.S.-China relationship.
From Washington to China, from Wall Street to whatever street cryptocurrency lives on, it feels like there has never been more for investors to keep track of.
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.
As Washington heads into its summer hiatus, we wanted to take stock of where things stand with several different issues that are on the minds of investors. So on this episode, we are going to try something a little different. Instead of hearing from one expert with a deep dive on a key issue, we're going to hear quick takes on several issues from five Schwab experts.
So, let's get right to it. First up, I want to get reaction to this week's Fed meeting, at which Chair Jerome Powell and his colleagues announced another 75-basis-point rate hike as they continue to try to rein in inflation. So what's next for the Fed? Joining me to help answer that question is Collin Martin, fixed income strategist at the Schwab Center for Financial Research.
Collin, with the July meeting now behind us, it will be almost two full months until the next Fed meeting in September. So what will the Fed be watching for over these two months to determine its next step? Do you think we are finished with these big hikes and that we may be heading back to the normal 25-basis-point rate changes?
COLLIN: Mike, it's all about inflation. After June's hot CPI report, Fed officials will be looking closely at every inflation release that comes out, and that includes both the CPI and PCE. So between its last meeting in July and the next meeting in September, there will be two releases of each.
The Fed has made it clear that fighting inflation is its number one priority right now, and Fed Chair Powell has stated that the committee would need to see clear and convincing evidence that inflation pressures are coming down before they slow down their aggressive pace of rate hikes.
And that clearly hasn't happened yet, as the Consumer Price Index, or CPI, rose by more than 9% year-over-year in June, which was the highest reading in over 40 years. And it really was just a shockingly high number.
When evaluating the rate of inflation, the Fed focuses more on the Personal Consumption Expenditures Index, or PCE. Now the PCE hasn't risen as much as the CPI lately, but it's also at 40-year highs. Now one reason why the Fed prefers the PCE is that its components change more frequently than those in the CPI, so it's a better representation of how rising prices are actually hitting consumers.
Despite those high readings lately, we do think that inflation should peak soon, as we're starting to see some signs under the surface that suggest that the rate of inflation should slow. One thing we watch is the "prices paid" component of various manufacturing indexes. They're still pretty high in absolute terms, but the trend is lower. Which means manufacturing companies and manufacturers might start to slow their pace of price increases. We're also watching wage growth, and that's been slowing down as well. When wage growth slows, consumers might rein in their spending a little bit, and that can slow the rate of inflation. So when you add all that together, we do expect the Fed to revert to smaller hikes later this year, like in the 50-basis-point or 25-basis-point range, since we do think we are near that peak in inflation. Now even if the Fed slow down the pace of its hikes later this year, it's still likely that the fed funds rate ends the year at 3% or higher.
And one final point, Mike, when we talk about inflation coming down, it doesn't mean prices will necessarily fall. It just means that the rate that prices are rising should slow.
MIKE: Well that's a great last point that you made, Collin. I think there's a lot of misunderstanding that Fed action will turn quickly into people seeing the prices fall on the shelves. But that's not quite how it works.
Well as we look ahead to the next couple of months and beyond, how will the Fed know if its policies are working?
COLLIN: Unfortunately, the Fed knows it can only solve for part of the inflation problem. It can't fix supply chain issues or the price of oil, but it can tighten financial conditions enough to slow demand. By hiking rates, the Fed is making the cost of money more expensive. And that means consumers could choose to spend less, which could lower economic growth.
The Fed really does need to thread the needle to slow growth because it doesn't want to send the economy into a recession, but that is a risk today.
The Fed will also be watching inflation expectations. Inflation expectations are important because high inflation expectations could result in some sort of self-fulfilling prophecy of sorts. If consumers expect inflation to keep rising, they might buy things now before prices rise, and then that pushes prices even higher.
The good news is that inflation expectations have been declining lately. One thing the Fed watches is the TIPS breakeven rate, which is an inflation expectation gauge. Right now the 10-year rate is around 2.4%, and that means bond buyers think inflation will average around 2.4% over the next 10 years. Now that's a lot higher than it's been in recent history, but with the CPI at 9%, that does seem relatively well anchored, and it's likely something Fed officials are pretty happy with.
And for better or for worse, the Fed is also looking at the slope of the yield curve as well. The yield curve is very flat today, and some parts of it are even inverted. But that tells us that the market believes that the Fed's rate hikes will succeed in slowing growth and bringing down inflation. If the yield curve was still very steep—meaning long-term yields were a lot higher than short-term yields—that would indicate that the markets were expecting inflation to keep rising, and that's not the case today. But the bad news is that an inverted yield curve tends to precede recessions.
Now we don't know if or when a recession will come, but we do believe that the risk of a recession is on the rise. So given all of that, we suggest bond investors move up in quality and play a little defense in the bond market. We'd focus on Treasuries and investment-grade-rated municipal and corporate bonds. And the riskier parts of the market, like high-yield bonds and emerging-market bonds, could suffer as growth slows.
MIKE: Well that's really helpful perspective, Collin. Big thanks to Collin Martin, fixed income strategist here at Schwab, for getting us going.
Next, I'd like to welcome back to the podcast Randy Frederick, managing director of trading and derivatives and Schwab's resident cryptocurrency expert.
Randy, after an incredible run to the stratosphere, cryptocurrency has seen a much bumpier ride over most of this year. The cryptocurrency meltdown has increased interest in Washington in regulating the crypto space. There's a bipartisan bill in Congress, the SEC and CFTC are jockeying for jurisdiction, Treasury has recently asked for public comment on the benefits and pitfalls of crypto, and agencies around the government are gearing up to report to the White House in response to the president's March executive order seeking to craft a government-wide policy agenda for crypto.
Even Coinbase, the largest crypto exchange, asked the SEC in a letter last week for more regulation. But you and I both know that lots of noise and discussion in Washington still means we're a long way from actual regulation. So what do you think are the pros and cons of regulation at this point for crypto companies?
RANDY: Well I think you have to consider what has happened this year to cryptocurrencies like Terra Luna; stablecoins such as TerraUSD, DEI, and Neutrino; crypto-hedge funds like 3 Arrows Capital; and crypto lenders such as Voyager Digital and Celsius, all of which have either filed for bankruptcy or fully liquidated. The most obvious pro, to me, would be to ensure that the remaining players are legitimate, safe, and properly collateralized. As I know you've heard me say many times before, Mike, the great crypto irony is that the one thing the industry needs most is the one thing it was created to avoid: regulation and government oversight.
If there is a con to more regulation, it would probably be, as I just said, avoiding regulation and government oversight is exactly why this industry came to be in the first place. Cryptocurrencies were born in the aftermath of the great financial crisis of 2008, as traditional finance, i.e., Wall Street and big banks, were bailed out by the government and U.S. taxpayers, despite being heavily regulated and insured by dozens of agencies such as the Federal Reserve, the U.S. Treasury, the SEC, the FDIC, and on and on. Early adopters of cryptocurrencies were highly distrusting of mainstream finance, which for years had contended that it could be self-governed. So they set out to create an easy peer-to-peer payment system that could decouple currencies and monetary value from governmental control, operate without a central bank intermediary, and without regulation. In other words, be self-governed. A utopian dream in a dystopian world, if you will. And just like Wall Street in 2008, what has happened to the crypto industry in 2022, has shown us that self-governance still doesn't work very well.
MIKE: Well Randy, let's flip the question around. What about the pros and cons of cryptocurrency regulation for investors?
RANDY: Well, I think many investors, especially younger investors, have been lured by the potential to make huge profits outside of mainstream investing channels, which many consider to be unfairly tilted toward institutional money and the very wealthy. But as is so often the case, the opportunity for huge gains rarely comes without equally huge risk. And it's not just price risk, but fraud, theft, structural and systemic risk, some of which has resulted in the tens of billions of dollars in losses. If the same type of regulation that protects funds an investor has in a money-market fund or shares of stock held in street name at a broker-dealer could be implemented in the crypto world, most of those risks, except for the price risk which is essential for investing, could be greatly reduced or eliminated. In other words, a crypto investor would no longer be just another unsecured creditor in a bankruptcy proceeding.
If there is a downside to further regulation and legitimization of the crypto industry, it's probably that doing so would be an invitation to many of those same wealthy and powerful players as in mainstream finance. And the so-called "little guy" would be relegated back to a subordinate position; in other words, the playing field would quickly become uneven again.
MIKE: Well, it seems like consumer confidence in cryptocurrency has taken a big hit this year. Do you think a stronger regulatory environment can restore that confidence?
RANDY: Well, you know, Mike, where there's big money to be made, there will always be big fraud. Because some people tend to be greedy and they're looking for a shortcut. I think common-sense regulation would improve overall confidence in the integrity of the industry, though perhaps not in all of the individual products. This industry is facing a colossal quandary in that it needs to swallow its pride and accept, maybe even ask for, more regulation to ensure its survival. While at the same time attempting to retain its rebellious, libertarian origins. By no means will this be easy to achieve.
MIKE: Well, thanks, Randy. As always, you've made sense of this fascinating world of cryptocurrency.
Well, now I want to turn to the more traditional stock market and get some perspective on how equities are reacting to the current environment. Making a return after his terrific debut on the last episode of WashingtonWise is Kevin Gordon, Schwab's senior investment research manager.
Kevin, one of the big stories out of Washington over the last couple of weeks has been the announcement by Senator Joe Manchin, the moderate Democrat from West Virginia, that he won't support the kind of broad economic bill that the White House has been pushing for over the last year. Manchin said in particular that he won't support climate-change measures or tax increases. But he did say that he would support a much narrower bill focused on healthcare. That bill, which is now moving on Capitol Hill, would basically do two things: reduce prescription drug prices and fix an issue with the Affordable Care Act that would have resulted in millions of Americans seeing their healthcare premiums increase by a huge amount. So if this bill passes Congress, how do you think that impacts the healthcare sector―and drug companies in particular?
KEVIN: So I think it might be a little bit of a broad-brushed way of thinking if we were just to say that the bill will impact the entire sector in a meaningful way. And one of the reasons I say that is because of where we're at in the economic and the market cycle. So if you think about healthcare, the sector, it's typically seen as more defensive area where investors will go to sort of hide out during bear markets; and that's largely proven to have been the case this year because healthcare is the fourth-best-performing sector on a year-to-date basis. And, I know fourth place might not sound the best, but consider the fact that healthcare is down by just under 10%, and the worst performer, which is Communication Services, is down by 30%.
And if you do peel the layer of the sector onion back, as I like to say oftentimes, and go down to the industry level, we've already started to see some drug companies actually price in the prospect for the lowering of drug prices. And for the better part of the past few months, their performance has generally been strong, but as we got to July it ushered in more volatility and risk to the downside as you saw odds of the bill's passage having increased during that time.
And even though the actual impacts of the bill are still ahead of us, the market, by nature, is a discounting mechanism, so that's why pharma, bio, and drug companies' stock prices having started to take a hit lately. And if anything, you're likely to see the acute declines up front, but we have also yet to see the passage of the bill.
So, if we bring it back to the broader health care sector as a whole, it's continued to hold up throughout heavy Washington debates over the past 12 months. And when you consider sector performance throughout that timeframe when the drug pricing debate started, the healthcare sector is in third place, right behind Utilities. Which is also typically considered a traditionally defensive sector, and further away from Energy, which has been in first place. And that has certainly been the exception, just given how strong oil prices have been. And we're still seeing a little bit of the benefit, even though it is fading a bit, from the reopening of the broader economy.
But if we look back at history, I don't think we can ever just look at one debate or one bill or event and tie it specifically to market performance. And one event to look at is the debate and the passage of the Affordable Care Act back in 2009-2010, and healthcare was squarely in the middle of the pack in terms of sector performance throughout that time. And also consider the timeframe that was the Great Recession during that time. And so, naturally, that's when defensive areas took a breather relative to cyclical sectors because we were coming out of the bear market that lasted from 2007 to the beginning of 2009, and also, I would say, as you always remind us, Mike, nothing ever moves in a straight line in Washington. So just to assume anything is a done deal and that there won't be any hiccups is wishful thinking, in my opinion.
MIKE: Well, that's definitely true, Kevin. I think you make a really important point about how it can be difficult to tie a particular bill or legislative action to a market reaction. And investors should be wary of trying to do that. Well Kevin, when you look at the economy more broadly, what is the most recent data telling you about the health of the economy and the prospects for a recession?
KEVIN: So the latest data we've received unfortunately continues to point more towards recession. And I'm mostly going to cover the Leading Economic Index, or the LEI, as we call it, from the Conference Board. And it's one of my favorites―we track it closely, and I'm going to cover it mostly because it's actually an amalgamation of ten indicators that lead the economic cycle. So it includes data like initial jobless claims, the new orders component from the ISM PMI surveys, consumer sentiment around the business environment, and then, also, the stock market, among others.
And we just recently got the June release and it was pretty weak across the board. So we saw the index fall on a month-over-month basis and actually register its fourth consecutive monthly decline. And the reason it's worrisome is that when you look at the history of the LEI, which goes back to the 1960s, we've never had a period when there were at least four consecutive monthly declines and a recession wasn't fast approaching or we already were in a recession.
And when we write a short, internal report on the LEI's release each month, we actually distribute a table, which sometimes makes it into our public reports, that tracks each indicator's level and trend. And the reason for this is because, and I'm going to utilize Liz Ann's oft-expressed adage here, is that when it comes to the relationship between economic data and the stock market, better or worse tends to matter more than good or bad. So just put simply, trends often matter more than levels.
And when we look at the levels of each indicator, four are registered as weak, which doesn't seem bad in absolute terms. But, if you move over to the trend side, seven indictors have trends that are in a worsening state; and the other three are what we call stable. So none are in an improving state; and when you look at the sea of red that is spreading in that trend bucket, it doesn't necessarily signal much strength for the overall economy or for the levels eventually.
And that downshift in the LEI has been consistent with almost all data that we've seen recently—from weaker home sales, to an increase in layoff announcements, and then, also, pretty dismal consumer sentiment. And that just means that as the weakness spreads, the market's choppiness will persist and risks to the downside likely won't abate anytime soon.
MIKE: Well, Kevin, that assessment is certainly aligned with what Collin Martin told us earlier from the perspective of the fixed income markets, where the indicators are also signaling that we aren't out of the woods just yet. Well, thanks, Kevin, for coming back to the podcast on a quick turnaround to provide your thoughts.
Well next let's pivot overseas, because there continues to be news coming out of China. For that, I'm happy to welcome back Jeff Kleintop, Schwab's chief global investment strategist.
Well, Jeff, let's begin with trade. Over the past several weeks, there have been a lot of conflicting reports about whether President Biden is going to cut some of the tariffs on imports from China that have been in place since the previous administration. It seemed like he was poised to do so. Then he said he needed more time, then perhaps he's going to wait until after he has a formal phone meeting with President Xi Jinping, something that is reportedly in the works. So what's your take on what's going on here? What would be the practical impact on the economy and investors if the president was to cut the tariffs?
JEFF: President Biden has maintained those Trump-imposed tariffs on more than $300 billion in Chinese imports. And you've got to go back to when Trump hit China with those duties, that was back in July of 2018. And those tariffs covered a lot of different things―industrial inputs like microchips and chemicals and consumer merchandise like clothing and furniture. But ending tariffs on consumer goods like hoodies and sofas isn't likely to help Americans where inflation hurts the most, and that's in food, fuel, and housing.
In an effort to do something about inflation, based on press reports I'm seeing, it's possible President Biden may cut the tariffs on maybe $10 billion of goods, but that's less than 3% of the total. And at the same time, the U.S. is indicating that it may open new trade investigations into subsidies to Chinese state-owned companies, and that could lead to higher tariffs in some areas. Politically, the tariffs on China are popular—although they haven't achieved their objective of changing any of China's behaviors—and Biden will look weak, especially to organized labor, if he rolls them back without concessions from China or at the same time threatening the potential for new or higher tariffs in other categories.
To me, it seems the White House is downplaying the role tariffs will play in the discussion about a range of issues. My sense is that the Trump tariffs didn't really increase inflation, and the cuts being contemplated are relatively too small to cut inflation meaningfully. I don't think investors need to worry about being surprised by developments in China's tariffs, especially in the near term.
MIKE: Another issue that's been generating a lot of buzz, especially here in Washington, is the three-way relationship between China, the United States, and Taiwan. House Speaker Nancy Pelosi is reportedly planning to visit Taiwan next month, and the potential trip has seriously ruffled China's feathers. China has indicated that it will respond harshly if Pelosi goes to Taiwan. The White House is reportedly divided on the issue, with some White House officials advocating that backing down and canceling the trip would look weak, while others believe the trip unnecessarily antagonizes China. At the same time, the head of the CIA recently said that he thought the risk of a Chinese military action against Taiwan would continue to grow as we move further into this decade. So what do you make of all this? Is this just normal posturing around Taiwan, or is there more reason for concern?
JEFF: Well the Taiwan issue has been around a long time, and I don't think we're near any particular red lines being crossed here. I mean I doubt that China would take action against Pelosi herself or try to otherwise interfere with her visit. But I wouldn't rule out the possibility that China could escalate military over-flights of the Taiwanese airspace and maybe ramp up navy patrols in the Taiwan Straight should the trip take place.
You know the U.S. has been sailing through the Straight quite a bit lately and sending surveillance aircraft over it, and Pelosi's visit could provoke China to maybe intercept one of these U.S. military vehicles. They've done it before. You know, the Chinese government never takes lightly supportive gestures or visits to Taiwan from leading Americans, but Chinese officials are especially sensitive right now. China faces internal economic challenges, as do many countries right now, and there's a lot of international pressure over human rights issues. And Chinese President Xi Jinping will convene a major party meeting in November, so the coming months are particularly delicate.
You know this is something, a development here, that maybe could drive intraday market volatility rather than something investors could expect that could change the longer-term trajectory of the market.
MIKE: I appreciate that perspective, Jeff. That's Jeff Kleintop, Schwab's chief global investment strategist.
Finally, one other issue that we've been following on the podcast is the slow but steady progress of retirement savings legislation. So I want to conclude today by bringing in Schwab's retirement expert, Rob Williams, who is the managing director of financial planning, retirement income, and wealth management here at Schwab.
As listeners have heard me say in recent episodes, there continues to be a lot of confidence among both Democrats and Republicans on Capitol Hill that an agreement will be reached by the end of the year to increase the age at which individuals have to begin taking required minimum distributions, or RMDs, from their retirement accounts. What's not clear is exactly when that age will change. The House bill would increase the age from 72, where it is now, to 73 next year and then step it up to 74 in 2030 and to 75 in 2033. The Senate approach would jump the age to 75 all at once—but not until 2032. We are hearing that something like the Senate approach is more likely, though the details remain unresolved. Maybe the age goes to 74 instead of 75. Maybe it happens in five years rather than 10 years. Both bills would also increase catch-up contributions to $10,000 for individuals approaching retirement age—an opportunity to sock away even more money for retirement. All of those details still have to be worked out.
So, Rob, from the perspective of people who are either in or approaching retirement, how should they be thinking about this? It can be hard to plan without knowing all the specific details, but what should investors be considering as they approach these decision points in their own lives?
ROB: Hi, Mike. I think that's a great point.
And, you know, ultimately they're trying to provide more flexibility, really, and the catch-up contributions, I think, is a no-brainer. If they provide it, you know―use it. Try to save as much as you can. On the RMD issue, ultimately trying to provide more flexibility in terms of when retirees start to take distributions, and ultimately you should have that conversation with a financial planner. I'd say more flexibility is good. It may seem like a good idea—and it is, to the extent that you could wait. But, from a financial planning perspective, it doesn't mean necessarily that every retiree should wait. As with most things, it depends more on your situation. And most of us know that investments in retirement accounts are tax-advantaged, meaning they grow without taxes, in the case of IRAs and 401(k)s, until you distribute—or withdraw—money from the accounts. So the longer money stays in the accounts, the longer money has time to grow, deferred from taxes.
But you do have to pay taxes eventually―you can't keep it in there forever. So when you do, you might have a larger account balance, and the larger your account balance, the larger your retirement distributions, and the larger your potential tax bill. So even if they do pass this legislation, it may make sense to smooth out withdrawals from you retirement savings before you get to RMD age, and not have a big jump in the years after you start RMDs, in your tax bill. And that's true today as well, and not just with the potential extensions. It's tempting to think of RMDs as the age that you should start withdrawals. But you're in control, and you can choose if you take them earlier.
And we've done some research on, and it shows that smoothing of those withdrawals—and taxes—may lower your lifetime tax bill and help your savings last longer. So take this control, and with the flexibility to wait longer and make a decision yourself is just good planning. So the big decision point, you asked and I believe, is just to talk to with a qualified financial planner well before RMD age―in fact, before you retire and map out what works for you.
And Mike, I actually have a question for you on that point. I'm interested in Social Security. We receive questions about it all the time, and Congress really doesn't look like they're doing anything much to shore it up at this point. The latest Social Security Trustee's report, which we watch, was published a few months ago and projects that benefits may need to be cut in 2034 to 79% or so of current benefits if Congress doesn't take action. Are you seeing any attention yet from Congress on this issue?
MIKE: That's a great question, Rob, and one I definitely get from investors all the time. I know you've followed this issue for many years, so you know the history of Congressional reluctance to touch what for a long time was known as "the third rail of politics."
While I do think the conversation has changed in recent years, and it's no longer considered career-ending for a member of Congress to talk about reforming Social Security, it's still politically difficult—and especially in an election year, like this one.
Part of the problem is that there are only so many options for how to strengthen Social Security—and all of those options are politically really difficult. You know, you can raise the retirement age, you can raise taxes, you can raise the amount of income that is taxed, you can reduce benefits—none of these are things that are easy votes for any politician. And the other factor is what you mentioned about time—that it will be the early 2030s before the problems in funding Social Security benefits really come into play. And that, of course, is multiple political lifetimes from now. So I think there just isn't yet overwhelming pressure on members of Congress to do something quite yet.
But I do think Congress is aware of the looming problems and recognizes that at some point in the next few years, it would be wise to take the necessary steps to shore up Social Security. We'll just have to wait and see if enough lawmakers have the willpower to do so.
Well, thanks to Rob Williams for joining me today. Rob published an article last month called "A Guide on Taking Social Security" that is really useful. You can find that at schwab.com/learn. And thanks to all my guests for taking the time to make this a lively and informative discussion.
Well, that's all for this week's episode of WashingtonWise. We're going to be taking a little break for the month of August, so we'll be back on September 15 with a new episode to kick off a busy fall. Take a moment now to follow the show in your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review—that really helps new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
